Debt Crisis 101

This is sub-chapter #14, of Chapter #4, Economics, of my ongoing rewrite and open editing process Random Rationality: A Rational Guide to an Irrational World. Would greatly appreciate any feedback, corrections, criticisms, and comments. If you want the full PDF of the book, then you can download it by clicking here—if you provide constructive criticisms in return, and live in the US, UK, or EU, then I’ll ship you a paperback copy of the book free of charge when it’s published. If you wish to read the previous chapters in one convenient place online, follow this link.

DEBT CRISIS 101

Imagine an eighteen-year-old rich college kid named Jack whose parents are rich. He goes to an Ivy League college with a credit card, and spends his college years buying everything he needs and wants: big screen TV’s, nice furniture, etc. He has his share of parties and his generous parents pay for all of it, no questions asked because their emotions get in the way of their rationality.

Four-to-six years later, he graduates college and becomes an apprentice lawyer, not earning much money at the beginning, though now he has his own credit card and is on his own. What do you think his spending habits are going to be like?

We all realize that most young kids would continue their spending habits as before, and rack up a bit of debt. Even adults do it now. “Oh, he’s just trying to keep up with the Jones, lame.” So Jack racks up a bit of debt, but because he wants to seem independent and show his parents he can take care of himself, he makes the minimum payments each month, which is all he can afford.

Now after a payment or two, he might think his debts are under control; he’s confident and proved that he is independent (to himself.) Jack goes on another spending spree to celebrate. Same process—he might make the minimum payments again or get a second credit card and pay off the first credit card. Rinse and repeat.

Eventually, his initial debts, still accruing interest each month, will no longer be affordable, and he won’t be able to make those minimum payments. Or he might not be able to get a third card due to bad credit. He is not yet making enough money and might not for a few years, but he’s confident that one day he will, so there’s no immediate problem, and he maintains the status quo. Imagine that…

Now look at the American and European governments and ask yourself, what’s the difference? You will realize there is very little difference in how fiscal responsibility works in an individual or in a government. In order to lend to governments; investors, other countries, central banks, or big institutions, need some assurance they can get their capital back with a bit of interest above inflation to turn a profit. If there is no assurance, foreign capital will slowly dry up, as is beginning to happen today.

The credit crisis we found ourselves in a few years ago was, of course, the precursor to this debt crisis we find ourselves in now. As during the credit crisis, all that toxic debt carried by private companies was going to sink the ‘too big to fail companies,’ and so governments bought it all up and carried it onto their books, increasing their own debt portfolio dramatically. But these governments were swimming in debt to begin with and were already running deficits every month of every year, and of course, paying the minimum repayments on their interest and paying off existing debt with new debt. At the prior levels, however, it was manageable, and there was no cause for immediate concern.

Then the constant stimulus and bailouts began, and they continued to accrue ever more debt. When they couldn’t sell enough debt, they printed it. Even money printed out of nowhere is loaned at interest—right now from the Federal Reserve at between 0 and 0.25% and in the EU at 1.5%, as of Jan 2013—and that extra money inflates the currency, robbing people who had the prudence of saving of their purchasing power, and worsening income inequality.

So with all this extra debt streaming in, plus the already running deficits that governments were, and still are running, you begin to see how similar they are to our dear and stupid Jack. Eventually, they will not be able to repay even the minimum repayments as interest rates eventually rise. And then what happens?

This moment could be happening soon. Japan is over 225% debt-to-GDP ratio, the USA is above 100% and climbing each month, and some of the European ratios are well over 100%. What’s going to happen when these governments can’t pay back their debts? That will be a major strike in the confidence of the global economic system, where trillions of dollars of government debt are held around the world in pensions and other benefits.

Trillions upon trillions of dollars are invested in these government debt traps, and the global economy is going to sink if anything ever happens to them. That capital needs somewhere to go, and when it doesn’t have any place to go to, bad things are going to happen (and a lot of it will disappear).

I’m sure that politicians know this; they have legions of economists and other smart people working for them. There is no way for them not to know. Yet, because the global financial system is based on confidence, no politician can tackle any of these problems for the following reasons:

1:

An electorate that will immediately vote them out of office. People know cuts have to be made—well some do—but no one can touch their entitlements, so of course nothing is cut.

2:

Their comrades won’t support them for fear of their electorate voting them out of office, too, which again shows the self-serving nature of politicians. Rather than taking one for the team, they pretend they don’t know.

3:

The global economy and all the stock markets in it, are based on confidence. A company can have great financials, profits to earnings (P/E), and other good financial indicators but still have a poor stock price. Or it can be the other way around; Enron, Lehman Brothers, and Facebook (when it first IPO’ed) make fine examples. Stock earnings and prices are based on future expected growth, so today matters less than tomorrow, or in economic parlance, the (theoretical) present value of discounted future cash flow. The same goes on an international basis and for fiat currencies. The value of a dollar today is based on future value it can bring, with next year’s expected tax revenue to repay that borrowed dollar with interest, along with demand for its bonds; and to make matters worse, emotion plays just as large a part, if not larger, than logic, which throws common sense even further into the black hole of financial markets.

This is a fundamental flaw in fiat currencies and the stock market; confidence is essentially a zero-sum game. There are very few things that we can remain confident in over a long-span of time: the moon, the sun, the stars, the comings and goings of the seasons, our need of food and water and sexual urges. What else can you say with absolute confidence will be around for all time?

So when confidence disappears, and the biggest economies are unable to borrow enough money to fund themselves and their entitlement programs, what will happen?

Look what happened in 2008. Lehman Brothers, which insured America’s mortgages, went belly up, and the global economy was brought to its knees because all the fancy derivative packages they sold couldn’t cover the payouts when growth in the housing market stopped, because the price of oil was too high.

Then western governments picked up all that debt, so what will happen when the government stops being able to absorb that toxic debt? Currently the US government pays $220 billion in debt repayments per year (six-percent of the government budget), and this number may rise to $1 trillion by 2020. (Note: the repayments are artificially small because the Federal Reserve has set its interest rate between 0 − 0.25%. If these rates ever rise, and they must once, or perhaps if, the economy starts recovering, the repayments will become even larger. Keeping interest rates at 0% is not possible forever, so sooner or later, those rates must rise.) In such a scenario, that of the government being unable to finance its obligations; stock, bond, and derivatives markets will tank everywhere. Politicians have shown us repeatedly that they will do everything to keep the status quo going. History is replete with such examples. Thus, we can almost be assured that no course of action will be taken to prevent this calamity until it’s too late to do anything, not that they have many options at this point anyway, short of political suicide, and an economic reset.

At the end of the day, it’s not the government’s fault alone. While they hold their fair share of blame in this circle of madness, we are equally to blame for allowing them to do as they please. Politicians are an extension of the society they represent. They are paid too much, get freebies others slave for, are put on a pedestal, are allowed to receive bribes in the form of lobbying, and are rewarded by the masses for saying what they want to hear instead of the hard truth they need to hear (this is really the only problem that needs fixing). So at the end of the day, the types of people who are attracted to these positions tend to be more leeches than public servants, paint rosy pictures where roses don’t exist and aren’t afraid to lie for the perceived “public good.”

All lies and half-truths eventually see the light of day; it is inevitable (especially with the internet). Lying for the sake of short-term stability forsakes the long-term march of human progress. This is what our civilization is seemingly transforming into: a self-serving, shortsighted engine of crony capitalism barely capable of thinking past the next quarter, long-term prosperity be damned. Our economics, so rooted in political dogma and ideology can, and should do better, but only if politics loosens it grip. As in the past, the separation of Church and State heralded a new era in human civilization, so to will (for the second time no less), a separation of Bank and State. (You’ll notice that the conjoining of Bank and State abbreviate neatly and poetically to BS. Indeed, BS is exactly what follows when the orgy of political malfeasance meets the relentless greed of Wall St.)

“If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours” ~ John Maynard Keynes (Economist)

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Fourat is a science writer, photographer, and author of Random Rationality and S3: Science, Statistics, and Skepticism. With help from the scientific community, he has compiled a book on GMOs: The Lowdown on GMOs According to Science featuring chapters by Mark Lynas, Ramez Naam, and others involved in the science and exposition of biotechnology. He claims no title other than that of self-educated layman.
Fourat frequently writes about science, especially biotechnology, on his blog: RandomRationality.com.
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